TBTF? Fuggeddaboudit!

Summary

Too Big To Fail has become a bugaboo.

But TBTF has never cost a cent.

It is a minor problem that does not require a solution.

The Federal Reserve Bank of Minneapolis recently held a conference on how to end Too-Big-To-Fail. There were many learned papers by many learned people. The conference was looking for solutions in search of a problem. Some of the participants almost said so.

Despite conventional wisdom, there is no significant problem about some banks (or other companies) being too big for the government to let them fail. In the U.S., the issue arises, perhaps, once in a generation. And when it arises, its cost is small.

In U.S. banking, Continental Illinois, which was declared failed in 1984 but whose actual failure date was 1982 (kept alive by the Fed and FDIC for two years) was the first bank that was said to be too big to fail. In fact. The idea dates to about then.

At conferences over the next 20 or so years, TBTF was discussed many many times. Most of the negative sentiment about it was that the TBTF banks were able to fund themselves at a lower cost because their creditors were less exposed to potential losses. That was unfair, it was contended, quite logically. My position always was and still is that TBTF is a natural condition. When a financial crisis appears on the horizon, the government becomes frightened that some large financial institution will set off a run on the system as a whole if it is allowed to fail. Such a fear leads to the creditors of that institution being protected by the government in one way or another.

The 2008 Experience

In 2008 that is what happened. First the creditors of Bear Stearns were protected by its sale to JPMorgan (NYSE:JPM) with $25 billion of support from the Fed. Rescuing Bear's creditors at the risk of $25 billion was a no-brainer. Bear did not have to be systemically important to make that small investment worthwhile. Unfortunately, the public and the markets did not understand that. Not realizing what a bargain the Fed had gotten, they thought the Bear Stearns case had set a precedent for future similar situations.

Next to go were Fannie and Freddie. They were not a TBTF case because the government had guaranteed their liabilities. Members of Congress were the only people in the world who did not know that. They were too guaranteed to fail. The government merely injected money to preserve the congressional fiction.

Then came Lehman. Denying that the government had the power to protect Lehman's creditors probably was a bad idea, especially as it was followed so closely by lending to AIG. But I do not know whether letting Lehman fail was right or wrong. If Lehman's failure had not set off the run on Reserve Prime Fund, things might have worked out differently. The run on Reserve Primary Fund did panic many financial markets participants.

Contagion then became a material problem. Merrill and BofA (NYSE:BAC) did the markets and the government a favor by doing their deal. Goldman (NYSE:GS) and Morgan Stanley (NYSE:MS), seeing the possibility that they could suffer runs, became bank holding companies to get under the Fed's umbrella (thanks to Rodgin Cohen's foresight and preparation). Thus they did not suffer runs.

Wells Fargo took Wachovia off the FDIC's hands.

Then the government used the TARP to provide capital to BofA and Citi (NYSE:C), which needed it, as well as to other large banks that may or may not have needed it, but Secretary Paulson did not want to identify the weaknesses at BofA and Citi. (Their plight was quite transparent to the market, but no great harm was done by forcing capital on all of the big banks.)

Combined with Fed actions to liquefy the markets, the capital for the big banks stopped what might have become runs on the system. And after a final accounting, there was no cost to the government.

Opinion in the aftermath

But TBTF, which few outside the financial sector had heard of or worried about, became the bête noir of populists, pundits, and politicians. TBTF achieved that status at a time when the forced mergers of 2008 really had made several banks too big to fail. (I should note that the surviving banks were delighted to grow. Each of them had reached a point where antitrust issues stood in the way of large acquisitions. The crisis atmosphere cured that temporarily.)

In that circumstance, Congress had to be motivated to do something about this scourge. Thus it became one of the primary targets of Dodd-Frank.

But no matter what Congress does, when a real crisis comes, Congress will not let a very large banking institution fail. The risks simply are too great.

Many people understand that. Therefore breaking up the big banks seems to them like the only solution. And I suppose it would be the only solution. Go back to prohibitions on interstate banking or something like that, take FICC authority away from anyone affiliated with a depository institution, etc. That is the sort of road one would have to go down if one truly were determined to end TBTF. And even that might not do it.

It seems to me that such radical solutions to a non-problem are unwarranted.

Funding Advantage

But what about the unfairness of the funding advantage?

Dodd-Frank and the Fed have corrected that problem. First, the living wills have put long-term creditors at risk and have reduced short-term creditors' leverage. Second, the higher capital requirements on large institutions have offset whatever funding advantage they may otherwise have had. These things are reflected in the views of the credit rating agencies.

Probably with more capital and stringent stress testing, the big American banks will be stronger in the next crisis and will not need to be propped up by the government. But if they have to be, they will be.

My advice is to fuggeddaboudit.

Runnable liabilities remain an issue

But if you are concerned nevertheless, then what you should worry about is runnable liabilities of all kinds. You might therefore take a look at John Cochrane's paper here. I am not yet convinced that Cochrane is on the right track, but at least he is focused on the right set of problems if you really want to do major surgery.

For my part, I am content to let the policies currently in force play out for a while. Constantly shifting regulation can do a great deal of harm. I think Dodd-Frank and the Fed are on a good track, even if it is not the best of all possible tracks.

With the rest of the world's banks so much weaker than American banks and American banks trading at reasonable prices compared with other stocks, maybe some of them are good buys now-unless of course the TBTF tomahawks destroy their value. We all have to choose our risks. Not taking any is not, for most of us, an option.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.